What To Watch

Sectors &#151 and hot-button issues &#151 for savvy investors to keep an eye on in 2006.

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Outlook 2006 | What to watch | Oil change

Sector Outlook: Real Estate

Anyone banking on the housing bubble bursting and showering the land with cheap property is likely to be disappointed in 2006. While industry pundits are predicting a slight slowdown, the average price of a house nationally is still expected to rise 5% by the end of the year. In fact, there's no bubble at all, says a report by BMO Financial Group, and the continuing higher prices are indicative of a strong underlying economy, not the speculative activity that shattered the market in the late 1980s.

By contrast, Canada's office market is expected to boom, after a decade of little growth. Commercial realtor CB Richard Ellis Ltd. expects 16.4-million square feet of new office space could be constructed in Canada in the next five years–that's 16 new 50-storey towers of one million square feet each. And 60% of the new buildings will be in downtown cores, primarily in Calgary, Toronto and Ottawa. “Everybody has had their foot on the brake since the early 1990s on [office] construction,” says Blake Hutcheson, president of CB Richard Ellis. “Vacancies have been coming down, rents have pushed up, and there's room for new development.”

One project already announced is Cadillac Fairview Corp. Ltd.'s 48-storey tower in downtown Toronto, to be completed in 2009. A couple of other Toronto towers are on the drawing board, but all are looking for lead tenants, and it's not clear whether those will come from expansion, displaced tenants looking for a better deal, or a bit of both, says Colin Loudon, partner and national director of Real Estate Services at KPMG Canada.

Either way, it's unlikely the increased construction will be enough to slake investors' thirst for real estate assets. “It's not just real estate companies; it's institutional capital looking for investments other than the public equity and public bond markets,” says Loudon. He cites interest from German, Israeli and other offshore investors, and expects hard deals soon. He also expects more companies to flip their real estate assets to management companies so they can redeploy the capital.

On the residential side, Re/Max in Mississauga, Ont., predicts sales will flatten or decline slightly in Canada's 20 major cities, but average house prices will rise everywhere except London, Ont., which is flattening after a record year. Royal LePage Real Estate Services expects Calgary and Edmonton to be particularly strong, with property values jumping 9% and 8%, respectively–no surprise given Alberta's booming economy. Montreal property values will increase by only 2%, but if you really want a deal, get yourself to Saint John, N.B., where the average sale price will be just $123,600–almost a quarter of what a house in Vancouver will cost. The West may be best, but the East is definitely least when it comes to your pocketbook. A.H.

Sector Outlook: Retail

Consumers have been doing their bit to keep the Canadian economy humming for the past few years. But while 2005 is expected to post glowing sales and profit figures for retailers, 2006 might be the year shoppers take a breather. Retailers used to a bull consumer market may have to reduce their expectations.

When the final figures for 2005 are in, retail profits in Canada should rise to record levels, to $9.5 billion, the Conference Board of Canada says in its recent report, Canada's Retail Trade Industry: Industrial Outlook — surpassing the previous record of $9.1 billion set in 2004. Author Louis Thériault notes: “Profits have been strong, despite weak price appreciation, in part because the rise in the value of the Canadian dollar has helped keep cost growth in check.” Retail sales have risen to “record levels” — an estimated $380.8 billion for 2005 — making them a key driver of economic growth. Easy credit and the housing boom have increased the tappable equity in people's homes. “Personal loans, including credit cards and lines of credit, have more than doubled from six years ago,” Thériault says.

Climbing interest rates, however, and their impact on already-high consumer debt burdens will work to keep retail spending in check in the future; Thériault predicts modest growth in real retail spending of about 2.5% per year between 2005 and 2009. Higher gasoline prices may also have an impact. Thériault notes that, in real terms, the current prices are about the same as in the early 1980s; consumers are devoting more than 3% of their disposable income to gas purchases.

Thériault also predicts stiff competition will likely mean cost savings from the higher Canadian dollar are passed on to consumers. He estimates retail profits will fall to $8.8 billion in 2006, before heading up again.

Ed Strapagiel, a retail specialist with Toronto-based Kubas Consultants, expects retail sales to grow by 6.2%, in absolute terms, to more than $392 billion in 2006. However, a lot of the growth will be in the gas-station sector of automotive sales, expected to rise 15.3%. Elsewhere, growth should clock in at about 5% in 2006, down from 5.2% in 2005. Home electronics is expected to grow by more than 8%, but the apparel category is likely to flatten, with growth of 3.3% compared with 4.3% in 2005.

At the company level, 2006 might be the year we finally see Wal-Mart Supercenters come to Canada. It is looking at sites in southern Ontario to build its supersize grocery/general-merchandise-format stores. Three will open in late 2006 with a location in London already confirmed. Perhaps Wal-Mart wants to take advantage of the current weakness at Canada's biggest grocer, Loblaw Cos. Ltd. (Loblaw has been having distribution- and logistics-related problems getting its own Real Canadian Superstore concept humming.)

As for Hudson's Bay Co. and Sears Canada Inc., their fates hang in the balance. HBC faces a hostile takeover bid from South Carolina takeover artist Jerry Zucker; Sears Canada's U.S.-based parent, Sears Holdings Corp., is moving to take the Canadian division private by purchasing the outstanding shares it doesn't already own. Some retail watchers suggest Sears Canada and HBC should merge, but Strapagiel says it's unlikely combining two weak players will make the resulting entity stronger. He adds that it all should make 2006 “a very interesting year.” Z.O.

Sector Outlook: Transportation

One of the biggest bits of news in Canada's transportation sector this past year was the deal struck in November between the U.S. and Canada on the location of a new Windsor- Detroit border crossing. Roughly one-quarter of trade between the two countries moves through that corridor by truck, so a direct link between Ontario's Highway 401 and Michigan's I-75 is good news for the logistics industry.

But is the need for a new bridge as urgent as everyone says? If there is another big story shaping up in transportation, it might well be that 2006 will mark the start of a shift away from trucks as the preferred mode of commercial transportation. Over the past two decades, many companies switched from rail to truck for cargo transportation. (Anyone who uses Canadian highways intimately knows the extent of the change.) But skyrocketing fuel prices, the ongoing struggle to attract drivers to the trucking industry, and the fact that emissions from Canada's trucking fleet are doing nothing to help us achieve Kyoto targets, have resulted in a sense that rail is on track for a rebound. “The stars are set for this industry going out the next five, 10, 15 years to make big, big leaps and regain market share,” Hunter Harrison, president of Canadian National, said during a recent earnings call.

Is it just hyperbole? We'll see, but Harrison's company's stock price is setting new records (the almost dozen derailments in British Columbia in 2005 notwithstanding), so the market is buying the story. Not to mention that a similar sense of rejuvenation exists in shipping. Canadian ports up and down the St. Lawrence Seaway launched a campaign in 2003, called Hwy H20, that port executives hope will convince manufacturers to move goods by boat rather than truck. And, in Quebec, the provincial government just extended a program that funds harbour improvements so that loads of wood chips from pulp mills can be moved off of roads and onto the water. It's all good news — for everyone except the truckers.

Also in turnaround mode is the airline industry, which is actually doing well for a change. Air Canada is out of bankruptcy protection, passenger loads are increasing, and there is even a new “open skies” agreement between the U.S. and Canada. While the deal does not represent outright cabotage — which would allow carriers of either nation to fly anywhere in the other's airspace — it should allow for more integration, competition and service in the North American airline sector.

The most uplifting — and unusual — transportation story in the year ahead could be the continuing expansion of the transportation industry beyond the Earth's atmosphere. March 27, 2006, is the scheduled launch date of the SpaceLoft XL, a privately developed rocket built by UP Aerospace that will lift off from the New Mexico Southwest Regional Spaceport and deliver several satellites into orbit. New Mexico is aggressively trying to take a lead in the rapidly developing (and huge) emerging market for commercial space launches. If you consider how satellite radio is taking off in the U.S., its potential for global expansion and the expensive service calls that will be required to sustain the service, the opportunity becomes clear. That is, if the required spaceport license arrives from the Federal Aviation Administration. That hasn't happened yet. But you know we're moving deep into the 21st century when we're discussing whether a spaceport license could be in the mail. J.S.

Sector Outlook: Telecom

By the time you read this, the three-member Telecommunications Policy Review Panel will likely have released its much-anticipated report; it was due before the end of December. But it doesn't really much matter. Maybe the panel will recommend the kinds of bold changes to the industry's regulatory framework that many telecom players have urged, and maybe not, but the federal government's slow, wobbly wheels ensure that nothing could take effect until, at best, early 2007.

The telecom industry won't wait, however. It will continue to charge headlong into its brave new world in 2006, as the telephone incumbents face growing competitive threats from cable companies' new phone services. Telus (once again firing on all cylinders since resolving its labour strife this fall) will battle Shaw in the West, but Bell has the greatest challenge, taking on Rogers (which owns Canadian Business), and the price-aggressive Vidéotron in the East. “[Bell is] up against two astoundingly formidable foes in the consumer market,” says Elroy Jopling, a Toronto-based analyst with research firm Gartner. Vidéotron has already found success in Quebec, and Rogers will gain ground on Bell in other markets, he predicts, despite its relatively conservative voice-over-IP offerings.

Bell and Telus may have a secret weapon, though: IPTV. This new, interactive form of television, which is delivered over telephone lines using Internet Protocol, could help counter the cablecos' forays into phone service. “IPTV is going to be as threatening to cable companies' distribution and economic models as VoIP is to telephone companies,” says Iain Grant of the Seaboard Group, a telecom consultancy based in Montreal. Watch for Bell to launch IPTV by the summer and for Telus to continue rolling out its service, which was recently unveiled to customers in Edmonton and Calgary. “It will be slow in happening, but IPTV has the capability to be better TV,” says Jopling. “Consumers might just begin to switch.” And that, in turn, could drive Rogers to lower prices on its phone service.

The consumer market won't be the only flashpoint, however. Competition in the business segment may heat up, too. One trend to follow is the emergence of telcos, especially Telus, providing clients with business services such as IT and human resources. Also, MTS Allstream, a division of Manitoba Telecom Services, recently announced it will now target large and mid-market corporate customers in an effort to streamline its business by $100 million over two years. “How MTS focuses Allstream in this next year will be pivotal,” says Jopling. “If they foul it up this time, it will not be well.”

An ominous warning–and one that regulators ought to heed as well. With the pace at which IP technologies are upending the status quo, the greatest mistake the government could make may be waiting too long. Just one more challenge for the industry in 2006. A.W.

Sector Outlook: Metals

For gold bugs, it's always a good time to invest in the yellow metal. But with gold prices now trading at their highest level in almost 25 years, they may just be right. Gold has pushed through the US$500 psychological barrier, and could go as high as US$1,000 an ounce over the next five to seven years — at least according to Pierre Lassonde, president of Newmont Mining, the world's largest gold producer.

While that US$1,000 target may be a little optimistic, the fundamentals for a prolonged gold rally seem to be in place, says a recent UBS Securities Canada report by Toronto-based analysts Tony Lesiak, Brian MacArthur, John Reade and Craig West. Gold prices have been on a tear for the past several months, and a combination of dwindling supply, heightened fears of inflation and continued weakness in the U.S. dollar are expected to push prices even higher in 2006. “We expect production growth to be anemic at best over the next several years,” says the UBS report. “The lack of supply and cost pressures should support commodity fundamentals.”

Increasing gold prices may finally help the shares of producers emerge from their long slump. Most gold-mining stocks have floundered over the past several years, as companies struggle with soaring production costs and try to replace their own declining production. But recently, gold shares have come back to life, as investors factor in the new higher prices, as well as speculate on which company will follow Placer Dome to become the next takeover target. Anyone looking to diversify his or her portfolio with gold should choose large, safe stocks, such as Newmont (TSX: NMC) or Barrick Gold (TSX: ABX), while those looking to take a flier on higher gold prices may want to look at smaller producers, such as Agnico-Eagle (TSX: AEM) or Kinross Gold (TSX: T).

All that glitters is much more than just gold, however. Base metals are promising to perform just as well — if not better in the year ahead. Since the beginning of 2004, copper prices have almost doubled, vastly outpacing gold's recent gains. As with gold, increasing demand and weak supply have pushed prices for copper, aluminum and just about every other base metal higher.

Those rising prices have helped spur a wave of consolidation in the base-metals sector, including, most notably, the recently announced takeover of Falconbridge by its former rival Inco. And high commodity prices should continue to push up the share price of companies in the base-metals market for the foreseeable future.

Still, an increasing number of investors are turning to aluminum stocks, such as Alcan (TSX: AL) and Alcoa (TSX: AA), says Victor Lazarovici, a New York-based mining and metals analyst with BMO Nesbitt Burns, in a recent research note. Aluminum prices have recently begun to rally, and they could see an extended period of strength. “Stick with aluminum,” says Lazarovici. “The sector… is now beginning to outperform, and we believe that the outperformance could continue for a very considerable period.” J.G.

Sector Outlook: Financial Services

On Dec. 6, 2005, the TSX composite index hit 11,096.82, a high it hadn't seen since September 2000. And no wonder: the Canadian economy has stood out in the world over the past couple of years. There's not a deficit dollar to be found, our commodities are in high global demand, and the prices of those resources are through the roof. Times are good.

But with a minority government in Ottawa — and now an election looming — many of the big questions hanging over the financial services sector remain unresolved. The one bright spot: the recent decision not to raise taxes on income trusts. The government first stepped into that market in September, halting advance tax rulings for trusts, which effectively put a halt on new issues. It caused more than a bit of confusion. But with the game back on (under a new tax regime) the big question for 2006 remains: What's going to happen to income trusts?

CIBC World Markets, which has marketed many of these vehicles, is predicting new highs for the trust market in the year ahead. But counterbalancing that rosy outlook are the many business trusts (distinct from real estate and energy trusts) that continue to surprise investors with distribution payment cuts. Will the year ahead reveal that over-exuberant bankers managed to sneak a pack of dogs into the market along with all the legitimate trusts? The message for investors is clear: Keep a close eye on how that distributable cash number–the main accounting metric for valuing trusts — is calculated.

Another question the government went out of its way to avoid addressing head-on in 2005 (after missing its own self-imposed deadline for a decision in December 2004) is that perennial Canadian chestnut, bank mergers. The question of whether Ottawa will allow the Big Five to fuse has hung over the sector for so long it is approaching the absurd.

Nevertheless, the banks took it upon themselves to answer this question in 2005 — in the negative. With no prospects for growth inside Canada, the Big Five roamed the globe looking for deals: RBC bought U.K.-based Abacus Financial Services Group Ltd.; TD snapped up the Banknorth Group in Portland, Maine; and the Bank of Nova Scotia recently acquired a Peruvian bank. The acquisition trend seems likely to continue in the year ahead. With the exception of CIBC (hobbled by Enron-related charges), bank coffers are swelling amid record profits — and most polls are indicating that another minority government may be on its way back to Ottawa. In fact, Tony Comper, CEO of the Bank of Montreal, recently mused he has $2 billion to spend, adding he sees better value in U.S. financial services companies than he has in the past.

Also on the sked for 2006 are talks on a single Canadian securities regulator, an issue that is beginning to resemble the merger question in both durability and degree of indecision. A strong discussion paper on the issue was released in December, but even capital-markets guru Purdy Crawford — who led the panel — doesn't seem to hold much hope. “I'm just not sure if the will is there as a result of the situation in Ottawa,” Crawford told Canadian Business shortly after his report's release. It's that minority government thing again — when it comes to getting things done, our uncertain political future could prove the new efficiency killer. J.S.

Sector Outlook: Steel And Automotive

Despite all the hype surrounding sky-high gas prices, not to mention engine sputters at General Motors and Ford, Canadian auto retailers had a respectable showing in 2005 — thanks to a healthy economy and consumer incentives. “Sales on the year are going to finish up about 3%,” says analyst Dennis DesRosiers, who originally forecast a 2% industry decline from 2004 sales of 1.53 million units.

In 2006, DesRosiers expects shipments to fall about 5%. “It all comes down to two things,” he says, “[consumer] income and confidence — and we have serious question marks on both sides.” Then again, Canada exports about 90% of the cars and trucks it produces to the United States, so it is the state of the U.S. economy that really matters to vehicle and auto-parts manufacturers.

According to contrarian investor Marc Farber's Gloom Boom & Doom Report, Uncle Sam's monetary policy will soon impoverish the majority of U.S. households, leading to social strife, protectionism and the breakdown of the capitalist system. DesRosiers is more hopeful. He says total North American auto sales could dip to 19.8 million in 2006, not far off estimated 2005 sales of 20.2 million. Auto production across the continent should also remain strong, finishing the new year at 15.9 million units, down from about 16.1 million in 2005.

Now the bad news. The Canadian auto-parts industry is heavily tied to customers like General Motors and Ford. The troubled Detroit duo is busy cutting costs, which is why even industry poster child Magna International had its outlook downgraded to Negative from Stable by Standard & Poor's. Investors should also note Magna is considering plant closures, despite posting impressive third-quarter income of US$159 million, a 20% gain.

The health of Canada's major steelmakers is also hitched to the auto sector. But non-contract steel prices are additionally influenced by players in countries like China and Russia. According to Morgan Stanley market researchers, offshore steel imports to the U.S. could continue to rise, after jumping 24% in October, putting downward pressure on North American prices. Which is why Morgan Stanley researchers are cautious on steel — despite the international bidding war that pushed Hamilton-based Dofasco Inc.'s market cap to $4.9 billion in December.

Steel analysts at J. P. Morgan, however, claim that cost surges in raw materials and energy have “flattened the global cost curve for steelmakers,” eroding the low labour cost advantage of steelmakers in developing countries. In other words, there may not be much cheap steel to import in 2006, so Canadian steelmakers could be in for another banner year. That's why angry Stelco shareholders (who will be wiped out if and when a restructured version of the Hamilton-based steel company emerges from creditor protection) are talking to lawyers. It's also why the steelmaker's new owners (read U.S. hedge funds) could make a killing, if Stelco II starts trading in the new year as currently planned, with a fire-sale initial market cap of about $143.5 million. T.W.